When the first company I ever worked for was acquired at a 44% premium, I was tempted to put a large percentage of my 401(k) retirement savings in company stock. At the time, I was in my early 20s and had a small percentage of a small savings in my 401(k). Thereafter, I understood the risk and never put any of my 401(k) retirement savings in company stock, even though the stock fund was available. Here are five reasons why.
Already invested in the company
If I am already working for my employer, my fate and my prospects are already tied with the company. That alone is proof I have my skin in the game. When the employer is having financial difficulty, I can expect a pay cut. When the company is doing well, I can expect a discretionary bonus, which in recent times has come in the form of restricted company stock. Gyrations in company stock value in my retirement account only magnifies my interest in the company.
Not required by law
The federal Pension Protection Act of 2006 required companies to allow diversification away from company stock in 401(k) plans. This means employees can no longer be forced to hold employer shares they receive. Even if an employee receives shares as a 401(k) match or performance bonus, he can sell the company stock after the stipulated period, and invest in other options available in their 401(k) retirement account.
Lack of diversification
I learned the benefits of diversification from my coursework in portfolio management and asset allocation. I know it is risky to invest more than 5-10% in any single stock. In fact my former employer had a restriction that allowed no more than 10% investment in company stock. Goldman Sachs has a 5% restriction. Interestingly, U.S. Congress placed a 10% limit on company stock in traditional pension plans back in 1974, but no cap exists on defined contribution plans like the 401(k), which are directed by employees. In fact, Employee Benefit Research Institute, a Washington-based nonprofit has reported that 5% of all employees (banks and non-banks) allocated more than 90% of their portfolio to company stock in 2010.
My employer allowed buying or selling in a particular fund in a 401(k) account once in 30 days. The restriction was more stringent for the company stock fund. To prevent trading on possible insider information, employees are typically not allowed to trade in company stock during the quiet period (end of financial quarter to earnings release) and typically a week after. This puts an employee at a disadvantage to other investors.
Not immune to large stock price declines
How can we forget Enron, Lehman Brothers, or Bear Stearns? Especially in the case of Enron, 62% of its $2.1 billion 401(k) funds were in company stock, which went from $90 in August 2000 to worthless in less than 18 months, and vaporized the retirement accounts of nearly 22,000 Enron employees. Although, retirement accounts are protected under ERISA in case of a bankruptcy or takeover, ERISA does not protect the loss of value of the 401(k) account from declines in company stock.
A recent Bloomberg article found that employees at the top five Wall Street firms had lost $2 billion in their 401(k) retirement accounts in 2011 by investing a large percentage of their 401(k) in their own company stock. Morgan Stanley employees had 24% of their retirement portfolio in company stock, which wiped out $570 million from their retirement accounts in 2011. Bank of America employees on average had 13% of their 401(k) accounts in BAC stock, which lost 58% of their market value in 2011.
While cautionary tales should not be ignored, I do believe 401(k)s are the most powerful retirement vehicle for young people, who can no longer count on Social Security. While we cannot diversify systematic risk away, new fee disclosures are making it even more advantageous to invest and manage a defined contribution retirement plan.
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